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Construction Financing – Contingency Allocations

—RMZ

Developer wants to finance the development of commercial property. Together with its architect and general contractor, Developer prepares plans and specifications and a detailed budget. The budget contains a contingency line item to provide a cushion for those pesky unanticipated cost overruns. Developer wants the lender to permit the Developer to allocate savings from any particular line item to the contingency line item and, conversely, to move funds from the contingency line item to any other line item where a cost overrun occurs.

A reasonable request? Maybe not.

To understand the Bank’s hesitancy, consider its underwriting analysis. The Bank may be financing the project, in part, on the as-is value of the real estate, owner equity and an as-built appraisal of the project. If the Developer completes the project on budget and on time, the Bank would likely not notice (or care) if Developer allocates money to or from a contingency line item.

However, the Bank needs to consider scenarios other than a perfectly budgeted construction project. For example, the Bank needs to look at the project as it progresses over time. If, at any point prior to completion, the Developer were to default, the Bank wants to ensure that the underlying value of the project collateral is sufficient to repay the outstanding loan balance. If Developer has allocated funds disproportionately to soft costs such as architecture fees, attorney’s fees and the like, the underlying value of the collateral in the project does not necessarily increase as the project progresses (or stalls). The value of the collateral existing at the time of a default must be sufficient to absorb the added debt and still meet Bank’s underwriting requirements to ensure Bank can safely recover all loaned amounts at any point in time during the development of the commercial property.